I read something on Barron’s today that truly baffled me; the article (here) quoted an analyst note from Morgan Stanley that said the following:

“MSFT is the cheapest stock in our coverage universe with a FCF yield of 17%, and Morgan Stanley’s “what’s in the price” tool suggests MSFT is pricing in negative EPS growth in three years, which we think is unlikely. If we strip out the Windows business altogether, the FCF yield is still double digits and the remaining company would be a double digit grower with a double digit FCF yield. So, clearly MSFT is already pricing in very low expectations for Windows and the PC market in general. The stock is too cheap relative to what is likely high single digit EPS growth longer term, particularly given the 3.5% dividend yield. Further, we think there is a powerful upgrade story around the Microsoft Business Division where we are as optimistic about the product set as we have ever been, while the execution in Server & Tools has been outstanding. Longer term, we are optimistic that MSFT can leverage its synergy across tablets, phones and the corporate desktops to provide a unified platform for application and content access, bolstered by its cloud services.”

That certainly sounds pretty bullish: Microsoft (NASDAQ:MSFT) is the cheapest stock followed by this particular analyst, followed by an expectation for high single digit EPS growth longer term – a growth rate that suggests that the current valuation is ludicrous.

Using 3% growth in perpetuity (in line with nominal GDP) and a discount rate of 12%, here’s the implied valuation at 7%, 8% and 9% annualized growth over the coming decade, along with the potential upside from the current valuation under those scenarios (this calculation assumes no value for the $50 billion in net cash in the company’s coffers):

7%

$45

+70%

8%

$48

+81%

9%

$52

+96%

Seeing that, you would expect this analyst to be jumping with joy (by the way, my numbers use starting FCF of $25 billion – below the numbers for the most recent fiscal year to adjust for $2 billion to $3 billion in annual M&A spend, on average); in fact, it’s quite the opposite (quoting the Barron’s article):

“Nevertheless, he thinks Microsoft faces 'a period over the next few quarters' where Windows 8 fails to 'catalyze' sales of PCs, and where corporate PC growth, which has generally been stronger than consumers, tapers off, compounding the problem. He also thinks the boost from the debut of new versions of non-PC products, such as SQL Server, had now pretty much been appreciated by investors and won’t add much in coming quarters.”

The analyst with a base case suggesting Microsoft is worth about $45 to $50 per share (basic calculations using his own numbers) considers the stock only worthy of an “equal weight” at this time, due to the fact that PC sales might be weak for the next 60, 90 or 120 days; if that doesn’t show you how useless analyst reports are to investors (meaning people who consider themselves partial owners of a business), I don’t know what will.

As always, I accept things for the way they are – and am thankful that the “smart money” is so blinded by near-term results that they can’t see an opportunity (by their own admission) when it’s staring them dead in the eyes.

About the author:

The Science of Hitting

I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves (potentially over a period of years). As this would suggest, I run a fairly concentrated portfolio by most standards, usually with the majority of the value in a handful of names; from the perspective of a businessman, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Comments

IMHO, the analyst did as well as can be expected. This analyst is saying two things.

1) MSFT is cheap today and the market doesn't care. If it did, it wouldn't be this cheap.

2) There is nothing on the horizon to make the market care, so the stock is not going to go up soon.

Like yourself, this analyst concludes that the stock is cheap.

Unlike yourself, he/she is expected to come up with price targets for next quarter.

This guy is being paid to produce Buy/hold/sell ratings based on higher/flattish/lower price targets. You need to predict all sorts of things, including the behavior of Mr. Market, to get it right. That is where it gets tough. I think he/she is giving it his/her best shot and being quite transparent about it.

I'm not assuming anything - the point is that by the analysts own assumptions, MSFT is a great investment; with that being said, he doesn't conclude as such - something I find quite bizarre...

Batbeer2,

Agreed 100%, and you've made my point - analysts are looking for short term targets; as such, their opinions/recommendations are meaningless to the owners of the business. I'm not saying he did a bad job - I'm saying that the answer to the important question for the investor (people who plan to own the company for more than a couple of days/weeks) is likely at great odds with what will be recommended in analyst reports.

The author must not follow the industry very closely - listen to calls from INTC or MSFT and you'll see just how much emphasis is on touch-enabled devices (Intel has recently announced that any product seeking the "Ultrabook" label MUST have touch). The number of PC's sold as of late with touch was around 5% - that will change dramatically in the coming 12 months (and prices will drop, with Intel targeting a price point of $599).

As I wrote a few months ago, I view this as an attempt to leverage the 1B+ PC customer base into the world of mobile and tablets. With a long term view, I think it's quick to see why the current release is in many ways the best thing Microsoft could have done (review my "Three Questions" article for more on this). Thanks for the comment!

>> With a long term view, I think it's quick to see why the current release is in many ways the best thing Microsoft could have done

Yes.

On my current PC, I will not be using win8... period. I tried it and the interface sucked.

BUT.... if my next PC is going to be a big "tablet" sitting permanentlly on my desk, what is it going to run?

Also, a decent 10" tablet with "metro" (I know it's not called that now) would be a pretty interesting alternative to my iPad. The interface would be better (subjective) and the functionality would be much better (objective). Windows 8 does things IOS can't (flash and office to name two).

I have no opinion on the stock but I'm fairly confident the "metro" interface is going to be with us for a long time. If you're feeling bearish, try finding out how much Logitech earns selling mice.

Maybe the company selling tissues for cleaning screens would be a good bet.

I think you'll be very surprised by the product offering at retail in the coming quarters - INTC and MSFT have made it very clear that touch will become standard on PC's (to use the "Ultrabook" name, Intel now requires that the device be touch-enabled).

Is your current PC touch? Have you tried Win8 on a PC with touch? From Intel's and Microsoft's research (listen to recent investor events), users on average find touch is something they want with Win8 once they have the ability to use it (don't quote me on the numbers, but I believe Intel's research showed that 80% of functions performed - out of 50-100 or so - were done via touch when users were given an option on a PC during their testing). I have Win8 on a touch PC (All-in-One with a 20" screen), and my personal opinion is that I would NEVER go back to a PC without it - even if it didn't have Win8.

You're response (essentially that Win8 is bad on PC's but good for tablets/mobile) is exactly what has been noted time and again (just like in the article highlighted by Swync2 above); touch is critical is changing that. Regardless, I believe that as a long term strategy, this is the best way to drive Win8 phone and tablet adoption - which becomes a game changer for other MSFT businesses along the way, namely Bing (take a look at Bing market share on Win8 devices vs. the overall PC universe - the data is a bit questionable, but I've seen numbers indexing at 2-5X above the overall PC space for Win8 users).

Apple's OSses are converging somewhat (iOS and OSX). But they aren't there yet. MS is there NOW. Unless Apple releases OSX for generic hardware, I can see where this is going in the next couple of years.

In short, you are right. MS has done precisely what it needed to do assuming most devices will be touch enabled in 3 years (I'm referring to installed base, not sales).

I agree with you - and the industry does too, thus why Intel and Microsoft are so intent on making touch standard. The hardware change will take time, with a big headwind being price points; as INTC recently noted, the price by the 2013 holiday season for an Ultrabook (meaning touch-enabled) with Core i5 should be at the $599 price point - much more bearable than the $800-900 that seems abundant now. I don't think you will need to wait three years for most devices to be touch enabled...

>> I don't think you will need to wait three years for most devices to be touch enabled...

Who knows, some may buy a $ 25 touchpad to upgrade their old PC.

As an investment I prefer Intel. If I find the time, I may do an article. The processors are in the most powerful PCs and can now scale down gracefully to smartphones too. A single core ATOM is a pretty powerful processor even if you pitch it against multi-core competitors.This of course means that core is also pretty (energy) efficient as well. Not to mention the fact that Intel has the best fabs by far (check the Capex). Apple should be watching these processors for their next iPad if they want to converge OSX and iOS some more.

It seems to me the old Wintel tandem is gearing up for another decade of world domination.

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